Monday, 26 November 2012

VALUATION OF CLOSELY HELD FIRM

Valuation of Closely Held Firm

What is a Business Valuation?

A business valuation determines the estimated market
value of a business entity. A valuation estimates the complex economic benefits
that arise from combining a group of physical assets with a group of intangible
assets of the business as a going concern. The valuation, which is part art and
part science, estimates the price that hypothetical informed buyers and sellers
would negotiate at arms length for an entire business or a partial equity
interest.

Valuation vs. Appraisal: How Do They Differ?

Valuation and appraisals are similar, but they are not
interchangeable. Most people are familiar with appraisals in their personal
lives. Often times people will have appraisals performed on a house, a car or a
piece of jewelry. The key difference between a valuation and an appraisal is
that a valuation includes both tangible and intangible assets, while an
appraisal just includes tangible or physical assets.

Business Valuation: Art or Science?

A business valuation combines quantitative financial
techniques with qualitative analysis of the business, the industry and the
economic conditions in general.

How can you determine the value of your closely held
stock?

The successful valuation of a closely held security
requires:

determining the proposed use of the valuation option

defining the meaning of the term "value"
which is appropriate for the proposed use of the opinion

analyzing and pricing the business enterprise
underlying the closely held security being valued

Analyzing and pricing the specific block of securities
being valued.

Reasons for Business Valuations

·To establish a price for a transaction

·Business planning

·Attract capital

·Aid in estate and gift planning

·Meet governmental requirements

·Buying or selling a full or partial interest in a
business

·A business merger or acquisition

·Admission or retirement of a partner in a business

·Property division in a divorce, when marital property
includes an interest in a business

·Payment of estate or inheritance taxes involving an
interest in a business

·Estate planning

·Preparing personal financial statements including an
interest in a business

·Employee Stock Ownership Plans (ESOPS) require
valuation of employer securities upon their acquisition by an ESOP, and at
least annually thereafter, under the Employee Retirement Income Security Act of
1974 (ERISA) and the Internal Revenue Code.

·Dispute resolution in cases where damages must be
determined for lost value of a business, such as breach of contract, patent
infringement, franchise disputes, antitrust suits, eminent domain, lender
liability, and dissenting stockholder suits.

The Components of a Business Valuation

IRS Revenue Ruling 59-60 states that valuations should
address the following issues:

·The nature and history of the business

·The general economic outlook and the conditions of the
specific industry

·The book value of the stock

·The financial condition of the company

·The Components of a Business Valuation

·The earnings capacity of the company

·The dividend paying capacity of the company

·Whether the company has goodwill or other intangible
value

·Previous sales of stock

·The market price of publicly traded companies who are
engaged in the same or similar lines of business

How is a Business Valuation Conducted?

The business valuation process can be broken down into
four components.

·Engagement process

·Research and data gathering

·Analysis and estimate of value

·Reporting Engagement Process

Issues in valuation

There are several issues that must be addressed at the
start of the business valuation process.

·Definition of the legal interest to be valued - (e.g.,
100% of the company's common stock)

·Valuation date - the date of the estimate of value

·Purpose of the valuation (e.g., estate tax, sale of a
business, business planning, etc.)

·Define standard of value: Fair market
value - the value in an exchange between a willing buyer and a willing
seller with a reasonable understanding of the facts. Fair market value is the
most common standard of value and the IRS requires it;Investment value -
the value to a particular investor based on individual investment requirements.
This standard is often used in merger transactions.

·Define the premise of value: Value as a going
concern - this is the value of a business assuming it will continue to
operate as a going concern; Liquidation value - this is the value of
a business that is not operating as a going concern, but has commenced an
orderly disposition of its assets.

·Form and content of the report

The standard of value

The standard of value is the type of value involved,
for example:

1.Book value,

2.Investment value, or

3.Fair market value.

Book Value

Book value is the amount reflected in the financial
statements for owner equity (assets less liabilities). The assets are usually
stated at historic cost, reduced by appropriate allowances for:

depreciation or amortization (in the case of
depreciable fixed assets),

Investment value is value to a specific individual
investor, as opposed to an objective impersonal market value to investors at
large. For instance, a uranium mine is probably worth more to a purchaser who
has access to nuclear technology than to a purchaser who lacks such access. A
steel plant that emits excessive pollution is probably worth more in a region
that has no anti-pollution restrictions than in a region with strict
environmental laws. The concept of investment value is value-in-use, rather
than value-in-exchange, which is market value.

Fair Value

This term means whatever it is defined to mean by the
relevant case or statute law, or industry trade practice or some other source.

Fair market
value is the most widely accepted standard of value used in business
valuations. It is the legal standard in virtually all business valuations for
federal and state tax purposes, and it is the standard for most other types of
business valuations, except in cases where a different standard is expressly
agreed upon or imposed by some legal requirement.

The Standard of Value and The Premise of Value

Whatever the premise of value may be, it can still
involve the fair market value standard with its “willing buyer(s)” and “willing
seller(s)”. Willing buyers and sellers can agree on transactions that are
composite or piecemeal, and on an orderly or forced liquidation basis.
Therefore the standard of value is not to be confused with the premise of
value. Despite some similarity in name, the standard of value is separate and
distinct from the premise of value. In order to keep these two important
concepts apart in our minds, it may be helpful to review the following summary:

Asset approach to valuing a business

The Asset approach methods seek to
determine the business value based on the value of its assets. The idea is to
determine the business value based on the fair market value of its
assets less its liabilities.

The commonly used valuation methods under this
approach are:

1.Asset accumulation method

2.Capitalized excess earnings method

Asset approach

The asset approach views the business as a set
of assets and liabilitiesthat are used as building
blocks to construct the picture of business value. The asset approach is based
on the so-called economic principle of substitution which addresses this
question:

What will it cost to create another business like this
one that will produce the same economic benefits for its owners?

Since every operating business has assets and
liabilities, a natural way to address this question is to determine the value
of these assets and liabilities. The difference is the business value.

Sounds simple enough, but the challenge is in the
details: figuring out what assets and liabilities to include in the valuation,
choosing a standard of measuring their value, and then actually determining
what each asset and liability is worth.

Market business valuation

The stats, expert opinions or both Market-based business
valuation methods are routinely used by business owners, buyers and
their professional advisors to determine the business worth. This is especially
so when a business sale transaction is planned. After all, if you plan to buy
or sell your business, it is a good idea to check what the market thinks about
the selling price of similar businesses.

The market approach offers the view of business
market value that is both easy to grasp and straightforward to apply.
The idea is to compare your business to similar businesses that have actually
sold.

If the comparison is relevant, you can gain valuable
insights about the kind of price your business would fetch in the marketplace.
You can use the market-based business valuation methods to get
a quick sanity check pricing estimate or as a compelling
market evidence of the likely business selling price.

Valuing a Business based on Market Comps

Pricing multiples for business selling price
estimation

All business valuation methods under the market
approach fall within one or more of the following categories:

Empirical, using comparative business sale data.

Empirical, which rely upon guideline public company
data.

Heuristic, which use expert opinions of professional
practitioners.

Income-based business valuation

To capitalize or discount?

A quick look at business valuation under
the income approach shows that you have two key types of
methods available:

Earnings capitalization methods.

Income stream discounting methods.

Given these two ways of doing the same thing you may
wonder:

Do these methods give the same business valuation
results?

Are there situations when capitalization or
discounting methods are preferred?

there are specific situations when these two types of
business valuation methods produce identical results. Strictly speaking, the
following is true:

if the business earnings are unchanged or grow at a
constant rate year to year, then the capitalization and discountingbusiness
valuation methods are equivalent.

Business Appraisal by Discounting its Cash Flow

This offers some useful insights:

You can use the current year's business earnings and
earnings growth rate as your business valuation inputs.

The capitalization rate is just the
difference between the discount rate and the business earnings
growth rate.

Business Valuation by Capitalized Multiple of Earnings

If business earnings vary significantly over time,
your best bet is to rely on discounting when valuing a
business. Since you can make accurate earnings projections only so far into the
future, the typical procedure is this:

Make your business earnings projections, e.g. 3-5
years into the future.

Assume that at the end of this period business
earnings will continue growing at a constant rate.

Discount your projected business earnings.

Capitalize the earnings beyond this point. This gives you the so-called
residual or terminal business value.